Municipal Archives

Municipal Bonds or Muni Bonds are bonds issued by local government bodies or Municipal Corporations. Bangalore was the first city to issue municipal bonds in India in 1997. Later, Ahmedabad followed by launching its municipal bonds in 1998. The funds raised by these municipal bonds are used for constructing bridges, parks, schools, and other public projects. Are these bonds safe? When should one invest in these bonds? What are the risks associated with these bonds? Let’s find out!

Why Do Local Bodies Need Bonds?

Urban Local Bodies, like municipal corporations, public townships, etc. have always had a lack of funding and resources. According to a 2018 report by NITI Aayog, “The total revenues of all Urban Local Bodies (ULBs) in India amount to less than Rs 1, 50,000 crores, approximately, 1% of India’s GDP.”

Most of the municipal corporations rely on grants or budgets allocated by state governments or the central government. Apart from these, they rely on water supply bills, property taxes, octroi, rents from municipal properties, vehicle registration fees, etc. The municipal bodies also had the responsibility of promoting socio-economic development in their areas. However, these are not sufficient to set up new projects or maintain already existing projects. To address this problem, local bodies started issuing municipal bonds.

How Good Are Municipal Bonds?

Tax-Free Income- Municipal bonds are usually tax-free or taxed at a lower rate. It is advisable to check the placement memorandum and necessary paperwork before investing in a bond.

Lower Risk – Municipal corporations of big cities set up projects like metro rails, public transport, roads, flyovers, public parking spaces, gardens, redevelopment schemes, and housing schemes. These big municipal corporations are likely to recover the money that they spend. Such development is seen only in Tier-1 and Tier-2 cities and generally gave a credit rating above A- going up to AA+ which is actually good.

On the other hand, municipal bonds of smaller towns and cities tend to have fewer development projects in hand and therefore might depend on taxes collected to pay back their bondholders. This means that the returns might get riskier for smaller municipal corporations. These bonds have a credit rating lower than BBB+.
Strict SEBI Regulations- SEBI guidelines have assured that only those municipal bodies that are financially stable and have the ability to pay back their bondholders can issue bonds. You can read the official SEBI guidelines for municipal bonds over here.
Lower Default Rate – On average, municipal bonds have a default rate of 0.18% as compared to corporate bonds which have an average default rate of 3%. This means that municipal bonds are more likely to pay back an investor’s money.

How Risky are Municipal Bonds?

Long Maturity Period – Most Municipal Bonds are issued for 10 years and generally start paying out after the 4th year from the date of issue. This means that Municipal Bonds may not be the best idea for those wanting to invest short term.

Lower Returns – Municipal bonds offer a lower rate of return than corporate bonds due to various reasons like limited revenue base, tax base and risk factors.

Call Risk – Like how companies ‘buy-back’ shares, bonds are ‘called’ back. Companies do so when the bond yield decreases and they want to increase the yield to attract more investors. When these bonds are ‘called’, they pay the bondholders the face value of the bond and the interest accrued on it. This can cause the bondholder to lose potential interest or pay more taxes on the amount received.

Dependence on Third Parties – Municipal projects aren’t the cleanest in nature. There is a lot of corruption and third parties (contractors) involved who may try to cut corners on the projects. Whether or not a project is completed depends on the company to whom the project was tendered to.

What Are Bonds?

A bond is a fixed-income security that a company or a government uses to raise money for a given period of time. In simple words, an organisation can raise debt/borrow money from investors (Mutual Funds, Foreign Investors, Domestic Investors, etc.). Bonds are low-risk investments that give fixed returns to an investor over a period of time.

Bonds are less riskier than shares, provide a higher return than bank deposits and certain bonds are even tax-free or are charged less tax than other instruments. Bondholders hold a greater preference than shareholders in a company. This means that in case a company shuts down, the bondholders will get their money before the common shareholders do.

Companies on the other hand prefer issuing bonds than borrowing money from the bank. This is because they may require strong financials, cash flows, and credit profiles, without which banks may not lend money. In bonds, it is completely at the investor’s discretion to invest money in those which abide by certain guidelines issued by SEBI and RBI.

Some Important Jargons

Face Value/Par Value- The price or value of a single unit of bond when it is first issued. However, it can be traded at below or above its face value/par value.
Premium and Discount- If a bond is traded at a price above its face value, it is said to be at a premium. If a bond is traded at a price below its face value, It is said to be at a discount.
The Principal or Par Amount- The total amount invested in a particular bond.
Maturity Date- The expiry date of a bond when the bondholder will get back the principal amount along with interest if any.
Coupon Rate- It is the rate of interest payable at a fixed interval till the expiry date (Annually, Semi-Annually, Quarterly).
Yield- Coupon Payment or Interest Payment received over one year divided by the face value of the bond. Example: If the face value of a bond is Rs.100 and the interest payment received is Rs.10, then the yield is 10%.
Yield To Maturity– Yield To Maturity or YTM is the total expected return for an investor if the bond is held till the maturity date.

Factors Affecting Bond Prices and Yield

Market Interest Rates – When the market interest rates decrease, the price of the bond increases. Let us take an example: If the rest of the market is providing returns at 2% interest and the bond meanwhile is providing 4% returns, then more people would invest in the bond than the rest of the market, and this will increase its demand and its market price simultaneously. When market interest rates increase then the price of the bond decreases.

Inflation – When inflation increases, the buying power of the interest earned also decreases. For example- If a bond pays 4% interest annually, and the inflation increases from 0% to 2% in a year, then the real return earned would be 4% minus 2%, which would be 2%. So the ACTUAL return received would be just 2%.

Credit Rating – Based on a company’s performance, its risk, and other factors, Credit Rating Agencies like Flitch and Moody’s rate the bonds according to their risk profile. The riskier the bonds, the lesser is its market price as very few would invest in them.

Types of Bonds

Bonds can be classified into many types based on the requirements of the investor. The bond market is an extremely diverse market with hundreds of different products. Not all bonds have a fixed coupon rate and Not all bonds provide regular coupon payouts. Mainly, Bonds are classified according to their issuer, the coupon rate, purpose, currency, country of origin, and much more.

Broadly speaking, based on the issue of the bonds, they can be classified as follows:

Government Bonds- Bonds issued by the state or central government
Corporate Bonds- Bonds issued by private companies
Municipal Bonds- Bonds issued by local governments or municipal corporation
PSU Bonds- Bonds issued by Public Sector Undertaking such as SBI, ONGC, etc.

Risks Associated with Fixed Income Securities

Inflation risk – that an increase in inflation might reduce the buying power of the returns received on the security.

Interest rate risk – that increase in overall interest rates shall occur which in turn will decrease the price of the bonds.

Currency risk – that exchange rates with other currencies will change during the security’s term, causing loss of buying power in other countries

Default risk – that the issuer will be unable to pay the scheduled interest payments or principal repayment due to financial hardship or otherwise

Example

Let us say, a company, Spanners Pvt. Ltd. manufactures nuts, bolds, and spanners. They wish to set up a new factory in Bangalore, but they do not have the sufficient capital required to set up the new factory. Spanners Pvt Ltd. decided to issue bonds of face value Rs 1000 per unit, with a coupon rate of Rs 100 paid half-yearly for a period of 10 years.

Kumar is a computer programmer with savings of Rs 10000. He wants to invest 50% of his savings (Rs 5000) in less risky investments. He does not want to invest in bank fixed deposits (FD) since he feels that they do not pay much interest and are illiquid. Kumar decides to buy 5 bonds of Spanners Pvt. Ltd for a par value or principal of – Rs.1000 x 5 Bonds – Rs. 5000.

10 years later, Spanners Pvt. Ltd has become a big company and now it’s time to pay its bondholders. Since Kumar has earned Rs 100 every 6 months as a coupon payout for 10 years, he has earned – Rs 100 x 2 times a year x 10 years – which equals to Rs.2000. Meanwhile, Kumar also gets his principal or par value back which is – Rs.1000 x 5 Bonds – Rs.5000.

In 10 years’ time, Kumar invested Rs 5000 and got back Rs 7000 making a total profit of Rs 2000.